Exchanges, Dark Pools, and OTC Energy: The Next 5 Years

Summary
Unless dark pools solve their transparency problem, Exchanges in general and the CME in particular will be the beneficiaries of structural changes coming to energy options. A battle is about to begin for control of the energy options complex. On one side are regulated exchanges, and on the other side are dark pools. The winner will be decided by who chooses the best market structure for attracting transparent liquidity and then frames that structure with the appropriate technology.

Dark Pools Defined
A dark pool (or OTC market) is an off-exchange network where buyers and sellers of securities trade. These sources of liquidity transact business privately and are not obligated to disseminate their activity publicly. Counterparty risk is mitigated either by ISDA agreements or in the case of Clearport through submission to an accredited exchange after the trade is completed.[1] Because trades do not occur on an exchange, they must be mediated by brokers.

Brokers and Dark Pools
OTC brokers offer institutional traders single-price liquidity with minimal information leakage. They negotiate between counterparties without showing either client’s hand. Brokers are invaluable for price discovery when an asset is not continuously liquid, as in options and back month swaps. These intermediaries are essentially the “order matching engines” within the dark pool. Their competition for trades is regulated Exchanges.

Electronic Exchanges
Exchange trades must occur at a centralized location, whether it’s a trading floor or an electronic order matching engine. Electronic Exchanges excel in continuously liquid contracts where a broker is not needed for order matching or privacy.

The Difference
The major differences between dark pools and exchanges are: transparency, regulatory oversight, and transaction guarantees. Exchange trades are publicly transparent whereas for the most part, dark pools are not. Exchange governance is under CFTC purview, while dark pools are essentially self regulating with government involvement in the most extreme cases. Because counterparty risk is essentially collateralized, an exchange guarantees its trades, where as dark pools offer no guarantees.

A dark pool is as small as a single broker connecting two clients on a trade. They are the traders who provide liquidity and the brokers who facilitate the order matching. They are sources of deep, blind liquidity that provide one-price executions to investors that want to minimize leakage into the marketplace. This private block trading is the liquidity that drives institutional markets. Without it, the marketplace would surely suffer.

The Death of Dark Pools
Business, technological, and regulatory forces are pushing OTC Energy Derivatives onto electronic exchanges. CME’s buyout of NMX, congress’s growing concern over speculators, and new order entry platforms are examples of the pressure being placed upon the OTC.
If the market forces continue down this path, OTC participants can at best hold a shrinking percentage of energy volumes. More probable is that just like equities before them, the OTC market’s business will move slowly but surely onto regulated accredited exchanges. For the time being, Dark Pool trading is a sunset industry.

Industrial Darwinism
Exchanges are working furiously to figure out a way to transfer dark pool liquidity onto their platforms. They are getting closer. The key is market structure. Some are trying to force the OTC markets onto thei

The good news is that it doesn’t have to happen this way. The bad news is that it will take a retooling of the mind set and business structure of OTC brokers, market makers, and other dark pool facilitators. The only other alternatives for them are to take the money and run, or fight an ocean of change that is coming down the line and watch their business valuations disappear along with their growth prospects.
They are not Clearport or an exchange. But dark pools must evolve if they wish to remain relevant. More on this later.

The Core Issue is a Failure to Communicate
The first task is to identify the core issue that must be addressed. That issue can be summed up in one word: Transparency. A lack of transparency is what has investors freaked. The lack of transparency is what scares the Fed. It is the reason the regulators are up in arms. More transparency will allow for more objective portfolio valuation, more liquid pricing, and better regulatory accountability.

Revisiting the opening paragraph: Business models now demand open architecture and transparency. Technology enables transparency. (It just makes more sense to get a dollar from a million customers than to get a million dollars from one.) Finally, regulators need transparency t o solve the accountability problem. Exchanges realize that transparent pricing is their best marketing tool.

The obvious problem for OTC Brokers is how to operate more transparently without losing their market making community. There are several ways to solve this. What has to happen is that the marketmaking community must first realize that they are in the same boat as the brokers. The nature of electronic exchanges is to remove all forms of intermediation and replace it with continuously liquid ECNs.

Before we dive into the energy situation, let’s look at the state of Dark Pools in other markets. What is happening in Energy is happening everywhere. It is not a one industry issue. It is a fundamental rethinking in market structure and regulatory practices.

Subprime, the FX Markets and Dark Pools

The Subprime crisis is a very bad thing for dark pools. Here is why. There was no public accountability or valuation mechanism to keep the players honest with themselves or to let regulators do their jobs. This comes back to transparency. All you need to know about what went down in subprime can be found here:
http://www.businesspundit.com/sub-prime/

Subprime debt, CDOs and their cousins trade in off-exchange dark pools. A typical transaction takes place between a bank and a hedge fund with an ISDA to (allegedly) cover credit risk. What could not be known was, the systemic risk implied when too many people have the same positions in a product that no one was willing to objectively value. Add to this opaque market poor risk and bankroll management (i.e. too much leverage), and you have a recipe for disaster.

Logical conclusion? Clean the mess up and demand more transparency going forward. Bad news for libertarians and bad news for Dark Pool operators like banks whose credit was downgraded.

The FX story is ongoing, and a story worth watching. It may have a big impact on the banking industry itself. Banks are essentially dark pools of liquidity. If dark pools go away, then banks lose an important source of revenue. No longer will they be able to shoot fish in a barrel. The legacy infrastructure that was a synergistic asset will quickly become a drag on their profit margins.

In 2006, the CME and Reuters formed FXMarketSpace; a JV to create the world’s first centrally cleared FX exchange. Since then FXMarketSpace has performed below expectations. This is because the FX market is a last bastion of the banking industry. Banks are the principal providers of liquidity here, and want to protect their franchises. So they essentially boycotted the exchange and strangled much of its growth. But things are different now. Exchange volumes are picking up, banks with poor credit are using the exchange, and clients are more interested in credit risk than perfect execution.

The Subprime crisis has affected how everyone looks at counterparty risk. And it is our opinion that liquidity will be driven to the FX Exchange in search of creditworthiness. While banks are deleveraging and cleaning up their balance sheets, FX business will relocate. This will be the currency market’s version of what happened to energy after Enron went belly up. There will be a flight to diversified counterparty credit risk. FXMarketSpace’s time may have come. (Buy Exchange stocks and sell banking stocks?)

Beginning of the End or End of the Beginning?

So, it is not an energy broker issue. It is the result of a rethinking about risk. Once upon a time, clients took counterparty guarantees for granted and worried about execution risk. As the global credit bubble deflates, counterparty risk and transparency are all the rage. What can dark pools and OTC participants do in the coming environment? There is a market structure already out there that preserves the business model, satisfies the transparency issue and still mitigates credit risk. It is just a matter of time before someone smart executes it in Energy Options.

Footnote:
1. From the time a trade is executed to the time Clearport clears it, there is counterparty risk. ISDAs do not remove counterparty risk, but put a price on it depending on client credit ratings.

For more information, contact Vincent Lanci at (212) 223-1000.

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Shorting

Summary

It is our contention that all regulation is imperfect, and that markets will find a way to expose truth. Government intervention only helps when it is in the direction of the trend. Bans on short selling, and other interventions designed to slow down or stabilize a market temporarily may work for a period, but in the long run they upset the equilibrium of a market. And that market must rebalance itself.

Overview

Despite the recent ban on certain sticks, traders can and most likely are still shorting them, albeit synthetically. As far as we can tell, these methods are legal; this is not an accusation of wrong doing.

We also do not aim judge the validity of the ban, nor can we assess the merits of a brokerage that allows clients to short stock not held by the firm.

Our goal here is to explain the structure and mechanism for alternate means of placing bearish bets on stocks despite those stocks being restricted from short selling. In this way, we hope to show that imperfect market (de or re)regulation by governments is always undermined by free market forces. Sometimes it happens in the short run, sometimes in the long run, but it always happens.

Sophisticated investors use various methods to short stocks. The tools at their disposal are indexes, futures, options. Some are Exchange based, some are OTC based. All can replicate selling a stock short quite effectively.

A Word about OTC Markets

Individuals with large amounts of capital have the OTC or Cash markets available to them. These are essentially private transactions that take place between a client and his bank. These deals afford the client: discretion, one price liquidity, and access to financial engineers who can create non standardized structures custom made for the client. An example would be an option structure called a collar.

Options Collars as Insurance Policies

A client with a stock position desires to sell it, but for some reason cannot. Using the OTC market he sells a Call option. This removes upside profit potential. He then buys a Put option using the call sale’s proceeds to offset some (or all) of the Put’s cost. This transfers upside potential to downside protection. He “collars” his position. Depending on the options he picks, he can be up to 100% protected. His collar would cost more, but the principle is the same as health or property insurance coverage choices.

Indexes

This one is simple. Bearish a stock? Find an index that has the stock in it. Short that index and then go out and buy every other stock individually except the one you want to short. This of course assumes the index is short-able. It also has some relatively high commissions.

Single Stock Futures

Trading in single stock futures (SSF) as a result of the SEC action was not restricted. People sold stocks short this way. SSFs are governed by the CFTC, not the SEC. this may change as we feel the regulatory agencies will consolidate under one umbrella. But for now, barring an action by the CFTC, SSFs are short-able.

Options

This one can get pretty complicated, as there are many ways to execute. But the effect is simple enough. Here is how it works; buying exchange listed Put options places direct downward pressure on a stock. The deeper in the money, the better the correlation with the actual stock price.

This is because every time you trade an option there is almost always a market-maker on the other side of the transaction. Now factor in that market-makers are exempt from the short selling restriction.

If you are buying a Put, they are most likely selling stock as a hedge. Marketmakers are exempt from the restriction on short sellers.

This is because they must as a function of their own business model sell stock short to hedge directional risk in their trades.

For more information, contact Vincent Lanci at (212) 223-1000.

Exchanges, Brokers and Bright Pools

Business, technological, and regulatory forces are pushing the OTC Energy Marketplace onto electronic exchanges. CME’s buyout of NMX, congress’s growing concern over speculators, and new order entry platforms are examples of the pressure being placed upon the OTC.

When the dust settles, OTC participants can at best hold a shrinking percentage of the energy market volumes. More probable though is that just like in equities before them, the OTC market’s business will move slowly but surely onto regulated accredited exchanges.

First, swaps brokers will be disintermediated. Then, OTC options brokers and their clients. What many traders may not realize is that independent market-making types will also be phased out. None will be needed in an LMM type centralized liquidity pool.

Arising from these seemingly depressing realities is a tremendous business opportunity for savvy brokers to grow their businesses. There are actually two different paths that an OTC broker may go down to survive. They must either: evolve into electronic brokers, or create more transparent dark pools.

Electronic Brokers

For those seeking to evolve with the changes coming, this makes the most sense. The Broker must first build a web site with Globex connectivity embedded. He must then broadcast liquid transparent prices (from multiple marketmakers) on the site for trading. He should also add market commentary, automated order entry and other content.

The value proposition to the market-making community is the fresh retail business. That is why they will do it. FCMs charge over twenty dollars per contract executed at the retail level (open an account at RJO if you don’t believe me). That is why an OTC broker should do it.

The broker who most efficiently combines transparent prices with marketing materials and good technology stands to become an OptionsXpress, ThinkorSwim or Lightspeedtrading in energy options.

There is hard work involved on this path. Business structure, client relationships, technology, IB relationships and marketing all are big factors in this concept. But the payoff is big. A business that successfully does this will morph from a company worth 1.5x revenues and a 25% profit margin to a company worth 12x earnings and a 50% profit margin. More likely the broker gets bought out in 2 years by a firm like the ones listed above.

Bright Pools

The other way to survive in the new environment is create a 3rd type of market structure, a Bright Pool. Imagine a dark pool where prices are transparent to all, regulatory oversight is present (even welcomed), and participant credit risk is mitigated.

It would first help to truly define what a dark pool is. For our purpose, dark pools are off-exchange sites where trades can occur and then be submitted somewhere for clearing. Dark pools are where the trade takes place. They can clear anywhere. It just so happens that OTC Energy clears mostly at Clearport. Therefore, OTC brokers themselves are dark pools.

To become a Bright Pool, Brokers must address the business, technological and regulatory issues facing the OTC industry. He must open his business architecture and broadcast price action globally without restriction. He must become a transparent provider of services to satisfy regulators. In clear terms he must:

1. Shine a light on the activity- post prices and markets on an easily accessible platform for all to see. It doesn’t have to be in real time, but it has to be reliable and public.
2. Create a Global virtual trading pit- use tech to create a hybrid platform that combines real time execution with broker assistance. Have complex structures trade with a brokers help. Have market maker
3. Broadcast it everywhere- make it web based so anyone can get on it at any time

More interestingly, OTC brokers with Clearport clients are the definition of a dark pool.

For more information, contact Vincent Lanci at (212) 223-1000.

EOO Arbitrage Summary

The Concept:

The Trade is based on a disparity between the conventional wisdom in current option modeling and statistical reality. In essence it is a function of current option models being incorrect in their assessment of the differences between American style options and their European counterparts as they relate to Early Exercise premium.

It exists for several reasons:

1. Commonly used option models do not account for the correlation factor and term structure in underlying commodity movement. They do not have a coefficient for other futures as related to the spot month.
2. Their valuation of Early Exercise premium does not properly handicap liquidity gaps, leptokurtosis, jump diffusion and skew for options.
3. The correlation between interest rates and Early Exercise probability should not be the most important determinant of premium in Commodity Options.

Early Exercise Defined

Early Exercise is a function of Variation Margin in the Commodity markets. Variation Margin is a lending process that results from a trader’s inability to cross margin option profits with future’s losses as long as the option position exists.

Except for infrastructure and systemic risk, there is no material risk to the trader or his Prime Broker, but that Prime Broker may charge a fee for lending a trader’s own profits back to him for margining purposes. This phenomenon is tied to regulations in the industry.

Early Exercise Conditions

An option is considered eligible for early exercise when all of the following criteria are met:

1. The in-the-money (ITM) option trades at parity with the future (100 delta)
2. The value of the equivalent out-of-the-money (OTM) option is less than the cost of borrowing on the ITM option
3. The theta of the OTM option is less than the cost of carry per day on the ITM option.
4. There is liquidity in the corresponding OTM option

If any of these 4 conditions are not met, then it will not save money to exercise the ITM option. Consequently, assuming the other side of the trade borrows money at the same or better rate, any option exercised early not meeting the requirements above will be a profit for him.

The Trade:

A sale of the American style option and a buy of the European equivalent. It is a neutral trade from a volatility and directional perspective.

The Risks
Risks are minimal at the option level but potentially large at the systemic level.

The main risk is Early Exercise.

Early Exercise is a function of interest rates, direction, volatility and liquidity.

1. Interest rates- as these rise, money is lost in opportunity cost.
• Early Exercise probability change is little to none
2. As the market moves away from strikes, their chance of Early Exercise increases.
3. Volatility- As volatility decreases, the chance of Early Exercise increases.
4. Liquidity- as liquidity in options with a 3 less delta increases, the chances of Early Exercise increases.
5. Strike Selection- little understood but very important, it is a function of leptokurtosis, Skew and mean regression as they relate to option liquidity.
6. Diversification of Open Interest- the less counterparties there are on the trade, the more likely an “All or None” scenario for Early Exercise. Therefore, volatility of Early Exercise increases as number of counterparties decreases.

Profitable Exit

Exiting profitably is dependent on several factors:

1. Familiarity with the marketplace and its universe of counterparties
2. Familiarity with the nuances of the underlying commodity and its term structure
3. Option Risk management
4. A thorough statistical understanding of Early Exercise risk.

For more information, contact Vincent Lanci at (212) 223-1000.

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